EM debt sell-off: Investors underweight local currency on QE fears

Emerging market debt managers have been taking underweight positions in local currency bonds as they expect the dollar to strengthen once the US Federal Reserve turns off the QE tap.

Monetary stimulus in the developed world had depressed yields on US treasuries and gilts, driving investors into high yield and emerging market debt as the hunt for returns intensified.

But comments from Fed chairman Ben Bernanke earlier this month that the US could taper its QE programme have sent the dollar and yields on US 10-years back up – two factors that could hurt local currency EMD.

“At the moment, we are underweight local currency debt,” said Grant Webster, manager of the Investec Emerging Markets Blended Debt fund, which combines strategies from across the firm’s £9bn EMD range.

“After the phenomenal rally we had, yields dropped very abruptly in April. We thought this was overstretched and moved to an underweight position, which benefited us through May [as treasuries rallied].”

Local currency EMD funds suffered their first net outflows in a year during June, as investors reduced exposure in anticipation of a rising dollar.

M&G bond manager Mike Riddell (pictured) also moved underweight local currency EMD earlier this month.

“If the US dollar continues to rally, local currency emerging market bonds could experience outflows,” he said. “US investors have allocated heavily into emerging markets throughout the past decade in order to benefit from a weaker dollar.”

He has positioned his Emerging Markets Bond fund more defensively, taking holdings in dollars to 85% and shorting Brazilian, Indonesian, Chilean and South African currencies.

Hedge strategy

Increasing dollar holdings also provided a hedge against the falling pound, Webster said. “When the dollar is strong and emerging market currencies are weak, the pound is also weak.

“In sterling [when the currency fell to lows of $1.37] the returns were actually positive in 2008. We get a lot of diversification by investing in the dollar asset class.”

Emerging market debt funds as a whole have taken $33bn of assets year-to-date, but saw an outflow of $1.5bn for the week to 5 June, their worst week for almost two years.

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